Economic Seer Says U.S. Not Addressing Cause of Crisis

In 2005, Raghuram Rajan stood before a room of prominent economic policymakers celebrating Alan Greenspan's legacy and presented a paper about how the world was headed for financial disaster. The University of Chicago economist was roundly scoffed at even though, as it turns out, he was right. Now that the crisis he predicted has abated, is he more optimistic? Not necessarily, because, as he argues in a new book, the real causes of the crisis aren't yet being addressed. TIME spoke with him about the conclusions he draws in Fault Lines: How Hidden Fractures Still Threaten the World Economy. (See seven key elements of financial reform.)

You write that growing income inequality in the U.S. fed the housing and financial crises. How so?
People at the 90th percentile of income distribution, typically your office managers, are pulling away in terms of income from people at the 50th percentile of the distribution, typically your grocery-shop clerk or manufacturing worker. Much of this is because of education. People with high school degrees and those without high school degrees are falling behind those who have a bachelor's degree and those who have higher degrees. The educational system hasn't kept up with the demand for highly skilled workers, and housing credit was an easy solution to that problem. People looking at their rising house prices pay less attention to their stagnant paychecks. This wasn't Machiavellian, but it was the path of least resistance. Bush called it the ownership society, and Clinton called it affordable housing, but they both focused on making loans for housing.

Is there historical precedent for using cheap credit as a political palliative, as you call it?
Absolutely. Both across countries and within the United States. In many ways, farmers toward the end of the 19th century were falling behind the rest of the population. A big piece of the Populist platform was to push for more credit. The result was a tremendous expansion of banks in the early 20th century. Some would argue that the immense extension of credit to the farm sector in the 1910s and '20s was a precursor to the Great Depression. (See the 10 steps that led to the financial meltdown.)

So what's a better way of dealing with income inequality?
To tackle the problem at the source. A large part of the population doesn't have the skills to compete in the modern economy. It's partly that they haven't kept pace with the technological change that's happening, and it's partly that people in the rest of the world are competing with them now. Being unskilled in the United States is a recipe for a life of stagnant wages and lots of uncertainty. We need to provide better skills to the population. One of the numbers that I cite, which is frightening, is that the fraction of people graduating from high school hasn't increased over the past 30 years. But it's not just fixing the schools, it's about families and the communities kids grow up in. It's a very big social problem, and that's why politicians say, "It's going to take too long to tackle this. Let's try something else."